1.1 What is Forex and How is it Traded?

What is Forex - An explanation‘Forex’ is short for ‘Foreign Exchange’, which is again a short term for "Foreign Currency Exchange".
 
 
Foreign exchange is the buying of one currency and selling of another.
 
 
Suppose a person in the Switzerland would like to travel to the U.S.A. Obviously, he can’t spend his Swiss francs there to pay for his expenses. What does he do? He goes to a foreign exchange dealer, hands over a bunch of Swiss francs and asks the dealer to change it into U.S. dollars. The dealer shows him the current exchange rate for converting one dollar into equivalent Swiss francs, displayed on his board, and tells him that, at that rate, he will get, say, Y dollars for the X Swiss francs handed over. The traveler agrees, and the dealer hands over dollar denominated traveler’s checks. These checks can readily be cashed by the traveler into dollar bills in the U.S.A and used for his expenses.
 
 
What happened here? The traveler handed over (sold) his Swiss francs. In return he got (bought) equivalent U.S. Dollars at the then prevailing exchange rate. This was a typical foreign exchange transaction.
 
 
On return the traveler has some dollar bills left over from his U.S. trip. Since these can’t be used in Switzerland, he returns them to the FX dealer, and is paid in Swiss francs at the new exchange rate. This time the traveler sold dollars and bought Swiss francs. This was another FX transaction, in reverse. 
 
 
Note that the exchange rate might have changed in the meanwhile. This is essentially what happens in the Forex market where transactions take place in dozens of currencies from various countries which are bought or sold at the prices (exchange rates) quoted on the FX market. These rates are quoted for currency pairs, for example the Euro and U.S. Dollar would be (EUR/USD) or the British Pound and the Japanese Yen, which would be the pair (GBP/JPY). Like the rates for the traveler, these rates are constantly fluctuating, and traders essentially try to make money by profiting from these changes.
 
 
The FX market is the alpha male of the global financial markets – the largest and most liquid market – dwarfing even the biggest equity markets.
 Picture depicting the Forex market size
 
Here’s a perspective on the relative size of the Forex market to the large equity markets:
 
Graph showing forex trading volumes compared with stock trading
 
 
The chart shows a comparison of the daily trading volume, in billions of dollars, of the Forex market and the stock markets at New York, Tokyo and London. As you can see, the stock markets are puny compared to the FX market.
 

How and what gets traded?

Picture for what is traded in Forex marketIn the example, the traveller traded in his Switzerland currency notes i.e. Swiss francs (and got in return a different currency – U.S. dollars. But what were the currency notes – they were real money. The traveller could use his dollars during the trip to the U.S.A for buying food, hotel accommodation, entertainment and whatever. Effectively, he traded in his Swiss francs money for U.S. money. In the Foreign Exchange markets too, exactly as in the example, we trade money.
 
 
Round the globe, round the clock, Forex is traded by importers and exporters, huge multinational companies, mutual funds, hedge funds, traders, banks, speculators to pay for goods and services, take or repay loans, transfer funds, and a host of other reasons. And they do this in a market where the currency prices are always fluctuating.
 
 
Currencies fluctuate because they are affected by the fortunes of the country they represent, which may be better or worse off compared to the currency at the opposite side of the transaction. The value of a country’s currency is determined by a large number of factors, chief among them being its interest rates, the condition of its economy, foreign trade, inflation and political governance.
 
 
Currencies get traded in the Forex spot market which, uniquely, does not have any fixed location or a centralized exchange for making the transactions! The NYSE is located at 11, Wall Street, but not so the FX market. The Forex market is an Over-The-Counter (OTC) market made up of a huge electronic network that connects banks, corporations, institutions, dealers and individuals across time zones and across financial centres in various corners of the globe. All the participants are constantly buying, selling and quoting for deals on this vast currency platform. The currencies fluctuate as they are constantly being bought or sold in response to news and economic developments taking place around the world.
 
Trading these fluctuations, profitably, would be your objective as an Forex trader, and this book will help you do it.
 
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